Tuesday, March 23, 2010

More on the U.S. Dollar, Deleveraging and Purchasing Power

by Charles Hugh Smith

Four correspondents offer four worthy perspectives on the dollar and debt.

Yesterday's entry The Contrarian Trade of the Decade: the U.S. Dollar generated a number of insightful commentaries.

Brendan O. reminded me that the ultimate measure of any means of exchange or store of value is its purchasing power as measured by how many FEW resources (food, energy, water) it can buy. Since this is a key part of the Survival+ critique, I am chagrined to have left it out of any discussion of money.

While you made many excellent points regarding the USD, I cannot agree that they hold importance equal to the fundamental requirement demanded of "money". That is - - "a store of value". I guess that is my concern with respect to your essay - it appeared implicit to me that the buck was being held forth as stable in this regard.

The USD is a currency, just like all the others - - it is not "money". As such it meets the requirements of a) serving as an accounting unit and b) serving as a medium of exchange.

I am in total agreement that one does not have imminent need to rush out and dump their dollars. Into what other currency would they go? (I am not aware of any true hard currency left in the world.)

One still needs USD to pay bills here in the USA so certainly those 'rainy day funds" need to stay in the home currency.

Yet - - if one is in the fortunate position of having a stash of paper currency (any) positions that they want to hold for retirement then I feel the need to point out that they are unlikely to hold purchasing power with those funds...even if in the form of USD.

"Checking the technicals" by looking at the buck's value on the USDX is like taking stock of the weather with a faulty thermometer and barometer.

Better that one looks at what the buck, the Cando, Euro, real, etc. buys when it comes to your "FEW" resources. Except for short-term speculative spikes (6 months or less in duration), the trending of price of the FEW reflects the declining value of currencies - - NOT an increase of perceived value of the underlying goods.

So, yes - the USD may be around for some time. It may actually "strengthen" but only against other currencies. It's potential to maintain purchasing power does not appear sunny as the world goes looking for more "FEW".

One line at the essay's beginning that distinguished "money" vs "currency" or "currency" vs "purchasing power" would have made all the difference.

It would be really cool though, to note that a reader thought it might be timely for you to temper the USD article with a link back to your thoughtful post some months back on the concept of purchasing power.

Thank you, Brendan. Here are several entries on purchasing power which prices "value" in terms of what FEW (food, energy, water) resources the medium of exchange or store of value can purchase.

Purchasing Power: The Only True Measure of Earnings And Wealth (December 21, 2009)

Housing, Leverage, the Dollar and Purchasing Power (September 25, 2009)

Inflation/Deflation and Purchasing Power (January 9, 2008)

Retiring in an Era of Declining Purchasing Power (June 11, 2007)

Frequent contributor B.C. provided a global context within which we can understand delveraging, debt and the forces acting on the relative value of the dollar.

The US$ will be relatively stronger because of (1) a secular era of risk aversion and liquidity preference by banks, firms, and households; and (2) a contraction of global trade and the flow of US firms' FDI and trade credits to Asia, reducing demand for foreign currencies and thereby creating a relative increase in demand for the US$, i.e., fewer credit-money US$'s flowing around the world and an increasing liquidity preference at home.

Bank lending is likely to decline 35-40% or more from the '08 peak, which implies another 30-35% from here. Such a decline implies a loss from the loan multiplier of equivalent GDP growth of 8-9%/yr. and 5-6% in compounded growth of private economic growth that otherwise would have occurred. This means that the federal gov't will have to borrow and spend at least $800B/yr. over the next decade just to prevent nominal GDP from contracting, whereas the gov't will have to borrow an additional $400B-$500B/yr. to cover lost receipts.

Most of the gov't borrowing and spending will be "replacement" spending, providing little if any net "stimulus" to the private sector from the decelerating secular trend growth.

By decade's end, bank loans will converge with the level of the monetary base (see Japan attached chart), implying that the Fed will double again or more the monetary base over the next 5-10 years.

Most of the digital credit-money cash created by the Fed since '08-'09 went to banks via the purchase of agency and MBS paper, i.e., an accounting balance sheet transfer of $1T in debt securities from banks (and some central banks) to the Fed and digital credit-money credited to banks. On-balance-sheet bank delinquencies and charge-offs now account for $650B-$700B, or more than three times their net interest margins and half or more of banks' cash assets.

Thus, broad money supply growth will likely grow no more than (1) the extent to which the federal gov't increases borrowing and spending (and the Fed prints credit-money to buy bank debt securities and directly US Treasury issuances) in excess of private sector contraction and the loss of receipts; and (2) the extent to which asset liquidation results in an increase in funds in checking, savings, and MMF accounts.

I estimate that avg. M2 growth will likely not exceed 2-3% for the next 5-10 years, even with M1 likely to grow in the upper double digits (and faster at times) from gov't borrowing and spending and the Fed expanding the monetary base. M2 velocity will continue decelerating, and most especially for private GDP.

As the debt-deflationary regime persists, and assets are sold to provide liquidity for firms, pensions, mutual funds, and households, the decline in credit-money asset values will overwhelm the gov't and Fed's ability to sustain incremental growth of GDP via borrowing, spending, and printing, whereas most of the Fed printing will end up circulating in the banking system.

As a consequence of the secular debt-deleveraging regime and liquidity preference, by mid- to late decade, banks, the Fed, pensions, insurers, and the top 1-10% of US households will be the largest holders of US public debt by far, exceeding the Japanese, Chinese, and oil producers as they run large deficits themselves in an attempt to prevent nominal GDP contraction.

Finally, the secular contraction of bank lending, deceleration of private sector growth and trade worldwide, and increasing risk aversion and liquidity preference will likely reduce liquidity for cash substitutes, hedges, and speculative assets, including gold and other commodities. While I am an advocate for gold as "insurance" against bankster and politicians' mischief, I suspect that gold bugs are going to be surprised, if not shocked, at how much the price of gold could fall in the intermediate term, as the risk increases for another global deflationary downturn.

B.C. offered this comparison of Japan's loans to its monetary base to illustrate how a nation in the grip of deflationary deleveraging can increase its money supply, yet lending continues to decline.

This is precisely what is happening in the U.S. as the Federal Reserve relentlessly attempts to expand money supply yet banks are lending less and less.

Japan illustrated the net result of this failed policy: 20 years of stagnation and the accumulation of a public debt so vast that it will crush the central State and economy.

Thank you, B.C., for a commentary which extends far beyond the standard understanding.

Eugene P. checked in with an explanation of why China must own a huge stash of U.S. dollars:

In addition to the factors you mention in your article today, note that China is constantly forced to buy dollars because of its fixed-rate exchange mechanism, which is another factor that would tend to prevent hyper-inflation of the dollar.

In case you aren't already aware:

1. China purposefully "pegs" the renminbi to a certain value, e.g., 1 renminbi is 50% of the US dollar.

2. China does not allow the value of the renminbi to "float," like other major world currencies that get traded on Forex (the pound, the euro, the yen, etc.). So even if the renminbi could theoretically trade at a higher (or lower) value on the free-market, the peg prevents such float.

3. In order to maintain this peg, China's Central Bank must readily convert renminbi into dollars at the established fixed exchange rate, on demand. By being able to oblige *anyone* who wants to convert renminbi to dollars, it effectively establishes the peg. In order to keep up this conversion, however, China must keep vast amounts of US dollars on hand, in reserve, to pay those looking to convert their renminbi.

4. This is one of the primary reasons that China buys US debt.

5. As the dollar's relative value decreases (because the rest of the world starts to see what a broken empire we are), China, by using this system, is actually forced to buy increasing amounts of US dollars (i.e., US Treasury-issued debt), or the value of the renminbi would actually *increase* against the dollar, which would destroy the comparative economic advantage that China currently enjoys as a low manufacturing cost, exporting nation.

6. US politicians *talk* tough about China's currency peg, but in reality, they know they can't live without it, since the US would basically grind to an abrupt halt without foreign nations like China buying our debt so that Washington could continue to function. It's a mutually beneficial circle of parasitism.

I don't think we'll get hyper-inflation here. No, I think what we're going to get here in the US is slow and steady inflation, you know, the kind the neo-Keynesians love, the kind that Monetarists tolerate as a necessary evil, the kind that most average citizens don't even understand - at least until they're on Social Security, and then they can't figure out for the life of them why the government's CPI adjustments still aren't enough to let them buy bread and milk and cheese. Then they start to have questions about inflation.

Thank you, Eugene, for clearly elucidating a key dynamic in the China-U.S. exchange rate "dance."

Longtime correspondent Bob Z. offered Bernokio’s Conundrum:

Bernokio’s Conundrum – Why the Fed Cannot Raise Interest Rates

Alan Greedscam’s response to the bursting of the stock market bubble in 2001 was to drive real inflation-adjusted interest rates into negative territory by holding the Federal Funds rate at 1% for most of 2003 – 2004. This was akin to putting a heroin addict on a pure heroin IV drip. Greedscam’s continuous denials notwithstanding, this negative real interest rate policy touched off the most speculative financial bubble in world history – the US housing bubble. In retrospect, Greedscam’s stock market bubble from 1997 – 2001 was essentially harmless. While many investors lost money, in general it was their money to lose. The housing bubble was different – it was fueled with borrowed money.

It took the Fed 3 years (June 2004 – June 2007) to normalize short term interest rates at around 5%. About 1 year later, in September 2008, the US economy crashed as the result of the Lehman Brothers investment bank collapse. Greedscam’s successor, Ben Bernokio, immediately embarked on the same type of response to the financial crisis as his predecessor – over the next 15 months, Bernokio reduced short term interest rates to zero, where they have remained now for the past 15 months.

To stabilize the banks, most of which would have been rendered insolvent by losses due to the housing bubble collapse, the US government forced the Financial Accounting Standards Board (FASB) to re-write certain accounting rules. This “extend and pretend” policy has allowed the banks to ignore massive losses in their real estate portfolios, presumably allowing these banks to earn their way out of their losses before being forced to acknowledge their insolvent status.

It is probably true that Bernokio’s policy of using the Federal Reserve to buy $1.25 trillion of mortgage securities has stabilized housing prices by putting a false floor under housing prices. However, this policy is scheduled to conclude at the end of the current month (March 2010). It is highly unlikely that private investors will now enter the mortgage securities market, given that these same investors have already lost hundreds of billions of dollars on bubble-era mortgage securities purchases.

As such, it is a near-certainty that mortgage interest rates are set to rise, perhaps from a current level of around 5% to as high as 6%. Unfortunately, a rise in mortgage rates from 5% to 6% will bring about a reduction in house prices on the order of 10%. For example, a household with a $55K annual income can afford to spend 28% of annual household income on mortgage payments – $15,400 per year or $1,283 per month. At an interest rate of 5%, a payment of $1,283 can support a mortgage of about $239,000. However, at a 6% rate that $1,283 payment can support a mortgage of only $214,000.

Any rise in mortgage rates will operate to reduce house prices. This will put further pressure on borrowers who are already tens of thousands of dollars underwater on their existing mortgages. It will also put corresponding pressure on the value of existing mortgage loan portfolios held in investment and bank loan portfolios everywhere.

It is not just the housing market that is addicted to Bernokio’s zero interest rate policy. Both the US stock market and the US government are addicted as well. Rising short-term interest rates will make the US dollar more attractive vis-à-vis foreign currencies, and will also make US stocks correspondingly less attractive. Rising short-term rates will also cause exponential increases in the cost of servicing US government debt, which is now increasing at a rate in excess of $1 trillion a year.

As such, it is now impossible for Bernokio to normalize US interest rates. Taking the heroin addict off the heroin IV drip will cause the patient (the US economy) to go into immediate cardiac arrest and die.

Thank you, Bob, for a clear critique of Bernokio’s failing policies.

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The U.S. No Longer Controls the Price of Oil in a Peak Oil World

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